NISM Series IV: Trading Mechanism in Exchange Traded Interest Rate Derivatives

This is Part 7 of our NISM Series IV Interest Rate Derivatives exam preparation notes. This post covers Chapter 6 — Trading Mechanism in Exchange Traded Interest Rate Derivatives (ETIRD). Understanding the exchange trading system, trading entities, order types, and risk management checks is important for clearing the NISM IV certification exam.

List of Entities in the Trading System Stock Exchange

A stock exchange is incorporated for the purpose of assisting, regulating, or coordinating the business of buying, selling, or dealing in securities. Its important role is to establish a nationwide trading facility for various financial instruments.

Clearing Corporation

The clearing corporation does clearing, settlement, and risk management for trades executed on exchanges.

Trading Member

A trading member is allowed to execute trades on his own account as well as on behalf of his clients.

Clearing Members

Clearing members have clearing and settlement rights in any recognised clearing corporation. They help in clearing the trades of their clients.

Types of Clearing Members:

Trading-cum-Self-Clearing Member
Trading Member-cum-Clearing Member
Professional Clearing Member

Investors / Clients

Investors/clients trade in Exchange Traded Interest Rate Derivatives (ETIRD) through trading members of the currency derivatives segment. The trading member accepts orders on behalf of clients and sends them to the exchange.

SEBI-Registered Stock Brokers and NDS-OM Access

To facilitate SEBI-registered stock brokers to participate in the Government Securities (G-Secs) market in the NDS-OM (Negotiated Dealing System-Order Matching), they may do so under a Separate Business Unit (SBU) of the stock broking entity itself.

Exchange Trading System

All derivatives exchanges in India provide a fully automated screen-based trading platform for ETIRD as part of the currency derivatives segment. These systems:

Support an order-driven market.
Provide complete transparency of trading operations.
Are designed to offer investors a safe and easy way to invest.

The Trader Workstation (TWS) is the terminal from which the member accesses the trading system. Each trader has a unique identification through a Trading Member ID and User ID.

Placing of Orders

The broker accepts orders from the client and sends the same to the exchange after performing risk management checks. Clients can place orders through:

Internet
Phone
Direct Market Access (DMA) — for institutional clients
Automated / Algorithm Trading (ALGO)
Smart Order Router (SOR)
Securities Trading Using Wireless Technology (STWT)

Order Book

The order book is an electronic list of buy and sell orders available for matching (not yet converted into a trade) for a specific security or derivatives contract, organized by price level. It lists the number of shares/lots being bid or offered at each price point (market depth).

Exchanges provide a spread order book separately for taking calendar spread combinations. A calendar spread is a contract where you buy/sell a particular month contract (Futures or Options) and take an opposite position of the same contract of a different month.

Main Components of an Order

Price
Time
Quantity / Number of Contracts
Security/Contract (What to buy and what to sell)
Action (Buy / Sell)
Client Identity (UCC) and Proprietary / Client Identifier

Types of Orders — Very Important for NISM IV Exam Price Condition Orders Market Order

A market order is where a trader purchases or sells their contracts at the best market price available to complete the order quantity. In a market order, there is no need to specify the price.

Limit Order

Limit orders involve setting the entry or exit price and then aiming to buy at or below the market price, or sell at or above it. Unlike market orders, the trader needs to specify the price.

Stop Order

A stop order allows the trading member to place an order that gets activated only when the market price reaches or crosses a threshold (stop loss trigger) price. Until then, the order does not enter the market.

Time Condition Orders DAY Order

Valid for the day on which it is entered. If not matched during the day, it is automatically cancelled at the end of the trading day.

IOC (Immediate or Cancel)

Allows the trading member to buy or sell a security as soon as the order is released into the market. If not executed, the order is immediately removed from the market.

GTC (Good Till Cancelled)

An order that remains in the system until cancelled by the trading member. It can span multiple trading days.

GTD (Good Till Days/Date)

Allows the trading member to specify the days/date up to which the order should stay in the system. At the end of this period, the order is flushed from the system.

Cancel on Logout (COL)

If a member enters an order with the COL condition, all outstanding orders of the user will be cancelled once the user logs out from the TWS.

Quantity Condition Orders DQ (Disclosed Quantity)

An order with a DQ condition allows the trading member to disclose only a part of the order quantity to the market.

MF (Minimum Fill)

Allows the trading member to specify the minimum quantity by which an order should be filled.

AON (All or None)

Allows the trading member to impose the condition that only the full order should be matched. If the full order is not matched, it stays in the books until matched or cancelled.

Proprietary Trading

Trading members are also allowed to trade on their own behalf (proprietary account). The facility to place orders on a proprietary account through trading terminals is extended only at one location of the member. Other terminals can only place orders on behalf of clients.

Types of Risk for Members Operational Risk

The risk of monetary loss resulting from inadequate or failed internal processes, manual and systems errors, or external events.

Market Risk

The possibility of incurring large losses from adverse changes in financial asset prices such as stock prices.

Credit Risk

The risk of default on a debt that may arise from a borrower failing to make required payments.

Legal Risk

Arises from the possibility that an entity may not be able to enforce a contract against another party.

Systemic Risk

The scenario that a disruption at a firm, in a market segment, or to a settlement system could cause a "domino effect" throughout the financial markets, or a "crisis of confidence" among investors creating illiquid conditions in the marketplace.

Pre-Order and Pre-Trade Checks Pre-Order Checks (before entering the order into trading system)

Price Range Check
Quantity Freeze
Single Order Quantity
User Order Value Limits
Cumulative Open Order Value Checks
UCC/PAN Check

Pre-Trade Checks (before execution of trade)

Trade Execution Range
Self-Trade Check
Market Price Protection
Kill Switch
Cancel on Logout (COL)

Trading Costs

While trading in ETIRD on behalf of clients, a trading member should specify various charges payable to avoid disputes. The following levies/brokerage can be charged to clients:

Statutory Levies
Regulatory Levies / Charges
Brokerage
SEBI Turnover Fees
Stamp Duty

Quick Recap for NISM Series IV Exam

Key entities: Stock Exchange, Clearing Corporation, Trading Member, Clearing Member, Investors.
Trader Workstation (TWS) = terminal to access trading system.
Order components: Price, Time, Quantity, Security, Action, Client ID.
3 price conditions: Market, Limit, Stop.
5 time conditions: DAY, IOC, GTC, GTD, COL.
3 quantity conditions: DQ, MF, AON.
5 types of risk: Operational, Market, Credit, Legal, Systemic.
Pre-order checks (6) and Pre-trade checks (5).
Trading costs: Statutory levies, Regulatory charges, Brokerage, SEBI Turnover Fees, Stamp Duty.

Next Blog Post: Chapter 7 — Clearing, Settlement and Risk Management in Exchange Traded Interest Rate Derivatives. We will cover clearing mechanisms, settlement types, margins, and the Settlement Guarantee Fund.

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